Inflation and Welfare in a Competitive Search Equilibrium with Asymmetric Information (with Lorenzo Carbonari and Robert J. Waldmann)

Abstract:

We study an economy characterised by indivisible goods, competitive search and asymmetric information. As in Lagos and Wright [19], agents need cash to trade in a decentralised market; buyers decide their cash holdings after observing the contracts posted by firms and experience match-specific preference shockswhich remain unknown to sellers. Firms are allowed to post general contracts specifying a price and a probability to trade, but the optimal contract implies a single price so that only those who value the good more than that price are able to trade. When the number of potential buyers is bounded, we show that the real price of the good is decreasing in the rate of inflation and, consequently, in the nominal rate of interest. Because of asymmetric information and indivisibility, monetary policy can exploit this relationship, and welfare is maximised away from the Friedman rule. The same result, but for a different reason, is obtained when the number of potential buyers is unlimited and buyers face an entry cost. Excessive entry causes a congestion effect, and an inflationary monetary policy can improve ex ante welfare.